What Is the 82/15 Safe Harbor Test for Foreign Corporations?
This rule provides a clear standard for foreign corporations to determine if investment income is functionally separate from their U.S. business activities.
Foreign corporations operating in the United States must determine if their income is “Effectively Connected Income” (ECI), which is taxed similarly to a U.S. business. For foreign corporations that also hold a portfolio of stocks and securities, a now-defunct provision known as the 82/15 safe harbor test offered a clear path to determine if income from those investments was ECI. This test provided certainty for foreign corporations managing investment assets alongside their primary U.S. business activities.
The Asset Use Test Context
The 82/15 safe harbor existed within a broader tax principle called the “asset-use test.” This test, found in Treasury Regulation 1.864-4, examines the relationship between a foreign corporation’s assets and its U.S. trade or business. If assets, such as stocks or securities, are held to meet the present needs of that U.S. business, any income they generate is classified as ECI. For example, funds held as working capital to manage day-to-day operations would fall under this rule.
This creates a “facts and circumstances” analysis that can be subjective and lead to uncertainty for taxpayers. The 82/15 safe harbor was established to provide a clear, quantitative exception to this rule. By meeting specific numerical thresholds, a foreign corporation could conclude that its investment income was not ECI, avoiding the ambiguity of the broader asset-use test.
Applying the 82/15 Safe Harbor
To qualify for the safe harbor, a foreign corporation had to satisfy two conditions related to its investment portfolio’s income and asset composition. Failing to meet both conditions meant the safe harbor did not apply.
The first condition was an income-based test that looked at the source of the portfolio’s income over a three-year period. At least 82% of the gross income generated by the investment portfolio for the three preceding taxable years had to be from foreign sources. Foreign-source income includes dividends and interest paid by foreign corporations or governments. This required careful tracking of the income generated by each security.
The second condition was an asset-based test measured annually. This test required that less than 15% of the average fair market value of the assets in the investment portfolio consisted of U.S. assets. A U.S. asset included stock in a domestic U.S. corporation or debt obligations of U.S. persons. The average value was determined by averaging the values at the beginning and end of the taxable year.
Tax Implications of the Test’s Outcome
The result of the 82/15 safe harbor test had direct consequences for how a foreign corporation’s investment income was taxed. The primary filing for a foreign corporation with a U.S. trade or business is Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, where this income would be reported.
If a foreign corporation successfully met both the 82% income and 15% asset tests, the income from that investment portfolio was presumed not to be ECI. This meant the income was not subject to U.S. net basis taxation and instead could be subject to a different tax regime, such as a 30% withholding tax on U.S. source payments or be exempt under a tax treaty.
Conversely, failing to meet either condition did not automatically classify the investment income as ECI. Instead, the determination fell back to the general asset-use test. The foreign corporation then had to analyze the facts and circumstances to argue whether the assets were held for the present needs of its U.S. business.